Fed warns that rates will rise

JAW, jaw or war, war? The US Federal Reserve last night delayed the launch of a worldwide round of interest rate rises - but they are on the way, and booming borrowing in Britain suggests there will be no delay here.

In holding its guideline rate at 1%, the Fed opted for jaw, but no one doubts that monetary war will come. It says low rates are likely to be removed at a 'measured pace'.

That goes for us, too. For nearly three years, the world's main economic groups have been enjoying remarkably low interest rates. That is down to a fall in inflation, and then the devastating September 11 attacks, after which central banks slashed rates to boost confidence.

Now global growth is moving ahead strongly and the Fed no longer needs to keep rates at rockbottom.

Everybody expects a series of rises. The caveat is the US presidential election in November. But it would hardly cripple George W Bush's re-election chances to have rates back up at, say, 1.5%. Once it starts, the Fed tends to move quickly.

In the early 1990s downturn, it cut rates to 3% until February 1994. The chart (below) shows what happened next; they went up four times in four months and within a year had doubled to 6%.

This time, RBS economist Ross Walker expects them to move to 3.5% by mid-2005 and 4.25% by the end of that year.

This will remove one barrier to rises in Britain. Our 4% base rate towers over the US's 1% and euroland's 2%.

If the Bank of England widens the gap, sterling may rise further. It gained 3% in three weeks after the Bank's February rate rise, making life difficult for UK industry. It was climbing again last night.

Fortunately industry seems in good shape, from the latest purchasing managers index. This rose in April for the twelfth month in a row. Manufacturing output seems to be growing at about 2%.

In truth, all the interest rate signals are turning to green. Borrowers are clocking up record levels of mortgage debt, which hit a 10-year peak in March. Consumers are making abundant use of their plastic.

The British borrower is a hardy animal. Two base rate rises from 3.5% since November have only slightly slowed the onward rush of debt. The far higher rates charged on credit cards are having little effect.

Borrowing is growing at 15% a year, more than three times as fast as incomes. Yet it is out of these incomes that the debts must one day be repaid.

Debt can safely grow faster for a while when the economy is turning up. The worrying thing is that these rises are coming when household debt is already huge.

Below the rapid growth of the headline numbers, there are some signs that borrowers are aware that the brakes have been touched.

Steven Andrew, at Isis Asset Management, points to store card borrowing, which has fallen every month since rates moved up in November.

Mortgage approvals, an important leading indicator, peaked last September.

These are hopeful signs that borrowers are not charging headlong towards the cliff top. But they are still moving at a fair clip.

Households' assets are rising as well as their debts. But a minority of borrowers is clearly in trouble. Others are reshuffling expensive personal loans into cheaper mortgage debt. The snag is that mortgages take 25 years to pay off.

Money markets are pricing in an eventual base rate rise to 5%. The Monetary Policy Committee's Paul Tucker has hinted at up to 5.5%.

There is an argument for getting there more quickly. Some say the Bank should lift rates from 4% to 4.5% on Thursday. That would shock the markets, something it has been keen to avoid.

The MPC has only made a halfpoint change once in its history - after September 11.

Bank governor Mervyn King is keen to cushion markets to any policy changes - aiming, as he put it, to be a boring banker.

That suggests he will keep on raising by instalments. But if gradualism does not work, King may have to use shock tactics - even at the risk of becoming interesting.